traderkenny
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The Weekend Commodities Review
A Market Review and Opinion Report By Head Analyst James Mound
For the Week Ending November 7th, 2010
This week I think it is a bit more important to discuss trading philosophy than it is to reiterate my bearish views on most commodities and expectation for strength in the U.S. dollar. This week I was reminded by a subscriber of mine of just how diverse of an audience reads my reports. With him in mind, I thought it would be beneficial to take some time to discuss trading approach, something I think can make all the difference in the world, especially when trading in markets that are at price or volatility extremes.
What lesson do you think most fund managers took away from the stock and commodity debacle of 2008? If you have heard it once in investing circles, you have probably heard it a thousand times – diversification. I think that when the stock market tanked, it revealed imbalanced exposure or an awareness of a lack of true asset diversification. Forget 10 years ago. Ask yourself if today, right now, the stock market rallied 4% in one day would nearly all of your stock holdings be in the green? What if the stock market declined 4% - would your portfolio all be in the red? I believe the stock market has become one stock, one industry, and I think it is time to throw out preconceived notions that you can diversify your investments within the stock market. I think it is time to focus on the diversity that commodities offer.
So what is real diversification?
While it is possible that the futures industry as a whole is correlated, as exhibited by 2008’s activity and even numerous trading days since, it is unlikely that over time this correlation will exist. By this I mean that it is quite possible that a euro currency collapse over a few months could impact all commodities in the same way global demand shifts can impact all commodities. However, over a few years this correlation will be very unlikely to hold up. Therefore one could gather that correlations change over time in commodities. One day, week or month the market may be focused on quantitative easing which pressures the dollar and spikes commodities. The next day, week or month the market participants may shift their focus to economic failure in a country like Greece and rally the dollar which plunges commodity prices. Then the following day, week or month the markets may focus their attention on U.S. employment recovery, which may rally the stock market, pressure the dollar but also rally oil but have little effect on grains, softs or meat sectors. This means that sometimes the main fundamental issue at hand can affect some but not all commodities and that awareness of this fundamental difference between stocks and commodities means commodities can provide true long term asset diversification. That being said, diversification amongst a wide variety of commodities is NOT enough.
What types of diversification exist in investments today? There is industry diversification, (varying percentages of your portfolio allocated to stocks, bonds, real estate and commodities) and market diversification (within the industry spreading assets amongst different markets and sectors like grains, cattle, cocoa and natural gas). Then you also have time diversification (trading price action over time frames within a given market), or trade design diversification (trading multiple strategies within the same time frame and market). These last two areas of diversification are often overlooked and these are the areas I focus on.
The reason I feel these two strategies deserve attention is because I believe it is ok to time a market or a forecast incorrectly if you are properly diversified. My strategies are designed with this in mind. The subscriber I mentioned earlier followed a recommendation I made that played my forecast for a collapse in silver. Now that forecast was a bit premature, if not entirely wrong, as the forecast has yet to come to fruition. I have never met a trader who timed every market move perfectly. However, I have met traders that designed trades to allow for imperfect timing. This subscriber followed my directional forecast but did it with his own trade design, one that took a severe loss because the silver market spiked about 10% after my forecast. Futures markets are highly leveraged and carry a substantial risk of a loss. When the markets are extremely volatile, this exposure is exacerbated. That increased risk can often mean having to exit trades prematurely and miss the ultimate move that occurs in the market. Utilizing certain option strategies may allow a trader to trade movement over time as opposed to having unlimited exposure to short term price action. If I made a forecast for silver to collapse, after which the market rallies 10% then declines 40% would my forecast be considered correct? Well if you were that subscriber you might say no, but if you designed a trade that allowed you to absorb the 10% move and ultimately stayed in the position for the 40% decline then you might say that I was a genius and nailed my forecast. The difference here being trade design and patience in the market place.
One of the focal points of my premium trade recommendation service, www.MoundTradeSignals.com, is to make recommendations that focus on trade design using a wide range of option techniques to capture different definitions of market expectations within the trade design. Allow me to use an example to explain:
Trade #1: Sell 1 December Silver at 24.00 with protective buy stop at 25.00 and target profit point at 23.00. By purely unbiased statistical probability there is an equal weighted chance the market will go up $1 as are the chances it will go down $1. This means the trade has a 50% chance of hitting your profit target and a 50% of being stopped out for a loss.
Trade #2: Sell 1 December Silver at 24.00 with protective buy stop at 26.00 and target profit point at 23.00. By purely unbiased statistical probability there is a 66.67% chance that the market will go down $1 before it goes up $2, or, in essence, the trade will hit your profit target 2/3rds of the time and get stopped out for a loss 1/3rd of the time. This is the law of statistical probability and obviously it does not take into account your personal market bias. This is the same law of statistical probability used to determine odds and payouts in the dice game craps, as well as many other games.
Using options, however, a trader has a chance to change the rules of the game. Let’s say that the silver market is at 24.00 and an option trader buys a 22.00 put that expires in 10 days. The cost of the put is $1,000 including a $50 commission/fee cost to enter and exit the option. At expiration the underlying futures market would need to be below 21.80 for the put to be profitable (the 20 cent difference between 22.00 and 21.80 represents the cost of the put as silver trades at $50 increments per penny so 20 cents times $50 = $1,000). Now what are the statistical odds of silver being below 21.80 in 10 days? American style options also allow the trader to exit the option prior to expiration which means if the market moves closer towards 22.00 prior to expiration than the anticipated movement already priced into the option, then it is possible for the option to increase in value prior to expiration prior to hitting your target profit point. By this I mean that volatility and price action have a direct affect on the price of the option during the life of the trade. In this hypothetical example let’s say that silver had recently averaged a daily price move of 50 cents per day. If the market moved in the same down direction everyday of the 5 remaining days to expiration it could theoretically get to your profit zone in time, albeit unlikely with that level of volatility and that little time to expiration. However, if the market started moving $1 per day, then it would seem more likely that your profit area could be reached prior to expiration, and therefore the value of the put option would increase to reflect this increased probability. This probability change is directly correlated to the volatility in the market and the time to expiration. So the main differences between a futures trader and an options trader is that a futures trader plays direction prior to delivery while and option trader plays direction, volatility and time prior to option expiration. Another important difference is that buying an option carries the defined risk and margin of the cost of the option, while a futures trader carries potentially unlimited risk of loss and variance in margin requirement. This means portfolio allocation becomes difficult as a futures trader but exact as an option buyer.
As a trader you should be acutely aware of the balance between risk and reward, but also the probability of the risk and reward. It is great to be able to say I am risking $500 to make $2,000 on this trade, but if the probability of risk is 4 times greater than the probability of the reward than it is tantamount to a 1 to 1 risk to reward ratio over time. With options you can change this probability analysis by trading changes in volatility over time which directly affect the change in statistical probability of given option trade. By spreading options, selling options, and buying options you can further change the definition of how the trade makes or loses money. Selling naked options or spreading options with net short positions can have unlimited risk of loss and a trader should properly educate him/herself about these risks before trading.
Now that you understand the basic differences between futures and options it is important to realize that you can use option strategies to sculpt an appropriate diversification strategy. Let’s use silver as the example again. Suppose you believed silver would plunge 30% sometime over the next 6-9 months. As a futures trader how would you approach this strategy? I believe the right answer would be that you do not have enough information to design a trade because you would not know where to exit the trade for a loss, and have a loss management strategy is the most important part of futures trading. It is easy to have an exit strategy when you are making money on a trade, but having one when the trade is going wrong is even more important when trying to be a long term successful trader. Let’s say that you found technical resistance $1 above current prices and chose to put your protective stop at that price (there is no guarantee that you will be filled at or near your stop), or you picked an arbitrary dollar risk tolerance $5,000 per contract away from the current price, or you based it on a percentage of your portfolio. Any of those scenarios may or may not take into account your true beliefs of the direction of the market, but because you are trying to be a disciplined money manager of your trading account you put these parameters in place. However this would be the wrong approach to trading in my opinion as it does not trade the view you have of the market, but rather limits your probability of success based on irrelevant conditions.
What if you didn’t have to trade that way?
Options trading opens the door to trading scenarios, and I provide the risk and reward scenarios for every trade design when I make recommendations, along with a scale out money management predetermined exit strategy. Utilizing options, along with a minimal amount of futures recommendations, Mound Trade Signals is designed to diversify a portfolio, covering a wide variety of markets and varying time frames. This approach is designed to provide a solid use of margin in an effort to maximize ROM (return on margin). It uses numerous defined risk strategies mixed with unlimited risk strategies and premium collection techniques. MTS helps to develop a more portfolio style approach to options trading while creating trade design that creates definition to the trade as it relates to my outlook for the underlying market movement. Explore Mound Trade Signals today and receive an extra 6 months free in your first year and other free bonuses including my online interactive options education program. You can cancel any time for a pro-rated refund and I am also available to answer your trade related questions during your subscription. Visit www.moundtradesignals.com for all the details and learn how to incorporate option strategies into your trading today!
Disclaimer: There is risk of loss in all commodities trading. Losses can exceed your account size and/or margin requirements. Commodities trading can be extremely risky and is not for everyone. Some option strategies have unlimited risk. Educate yourself on the risks and rewards of such investing prior to trading. Past Performance is not indicative of future results. Information provided is compiled by sources believed to be reliable. JMTG or its principals assume no responsibility for any errors or omissions as the information may not be complete or events may have been cancelled or rescheduled. Options do not necessarily move in lock step with the underlying futures movement. Any copy, reprint, broadcast or distribution of this report of any kind is prohibited without the express written consent of James Mound Trading Group LLC.